What it means
An option gives its buyer the right, but not the obligation, to buy or sell an underlying asset at a fixed price (the strike price) before or on a set date. Equity options are based on individual shares.
Non-equity options are based on other things. Index options are the best-known type.
They track a basket of shares, such as a broad market index, and are usually settled in cash rather than by delivering shares. Currency options and options on futures serve companies that need to manage exchange rate or commodity price risks.
The appeal for businesses is hedging. An exporter expecting foreign currency in six months can buy a currency option to protect against a fall in its value, while keeping the benefit if the currency rises.
A fund holding a diversified share portfolio can use an index put option to limit losses in a market fall. Pricing depends on the same factors as other options, including the distance between the market price and the strike, time to expiry, volatility (how much the price moves around) and interest rates.
The buyer pays a premium upfront, which is the most they can lose, while the seller takes on greater risk in return for the premium. Tax and regulatory treatment can differ from equity options.
In the United States, for example, certain non-equity options receive blended tax treatment of gains and losses, so investors and corporate treasurers should seek advice before relying on any particular result. Trading rules, margin requirements and reporting also vary between exchanges.
Because the contracts often have large multipliers, small price moves can mean large gains or losses. Anyone using them should set clear limits and understand how the position will behave in different market scenarios.
For non-specialists, the term is mainly useful for recognising what a treasury team means when it mentions index or currency options.
In practice
Real-world examples.
Example
A fund manager holding a diversified portfolio of shares worth $50,000,000 buys index put options as protection against a market fall. The premium costs 1% of the portfolio, or $500,000. If the market falls sharply, the puts gain in value and offset part of the loss. The cost reduces his returns in rising markets, so he buys cover only when he sees clear risks.
Example
An importer must pay a supplier 2,000,000 euros in three months. To protect against a rise in the euro, he buys a currency call option. If the euro rises, the option limits his extra cost, and if the euro falls, he lets the option expire and buys at the lower market rate. He values the flexibility, though the premium makes it more expensive than a forward contract.
Example
A grain trader buys options on futures contracts to protect against a drop in wheat prices. The premium is the most she can lose. If prices fall, the option gains value and offsets the lower value of her stored grain. If prices rise, she lets the option expire and sells her grain at the higher market price.
Formula
Calculation
Call option payoff at expiry = (index level - strike price) x multiplier, if positive; otherwise zero
Profit = payoff - premium paid
An investor buys an index call option with a strike of 4,500, a $100 multiplier and a premium of $4,000. At expiry the index is at 4,560. Payoff = (4,560 - 4,500) x 100 = $6,000, so profit = 6,000 - 4,000 = $2,000.Case study
Seen in the real world.
Corvid Exports is a fictional company that sold goods abroad and expected to receive 3,000,000 units of foreign currency in four months. In this illustrative story, the treasurer feared the currency would weaken and bought put options that guaranteed a minimum exchange rate, paying a premium of $45,000. The foreign currency was worth $0.50 at the time, so the expected receipt was worth $1,500,000.
Four months later the currency had fallen to $0.46, and the receipt would have been worth only $1,380,000 without protection. The option let the company exchange at its guaranteed rate, worth $1,500,000 less the $45,000 premium, giving a net $1,455,000. The treasurer noted that if the currency had risen, the company would simply have let the option lapse and enjoyed the gain.
Corvid made hedging with options a regular part of its policy but set limits: no more than 60% of expected receipts for any quarter, and every option had to be reported to the board. The treasurer pointed out that options cost more than forward contracts, so the company used them only where the benefit of keeping the upside was worth the premium.
Watch out
Common mistakes.
- Assuming every option is an option on a share. Many are based on indexes, currencies, rates or futures.
- Forgetting the multiplier. Index and futures options often control a large amount of exposure for a small premium.
- Ignoring the premium when judging results. The premium is a real cost and can turn a small payoff into a net loss.
Questions
People also ask.
What is the main difference from an equity option?
The underlying asset is not a single company's shares, and settlement is often in cash.
Who uses non-equity options?
Fund managers, corporate treasurers, traders and exporters or importers managing market risks.
Are the tax rules the same as for equity options?
Not always, so check the rules that apply to your jurisdiction and contract.
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